VolX: Realising Volatility

The Volatility Exchange (VolX®) bears little resemblance to a conventional exchange and is probably best thought of as being a virtual exchange. Its realised volatility contracts can be based upon products already listed on any existing exchange or trading platform to provide a new market complex of uncorrelated instruments. Automated Trader’s founder Andy Webb recently caught up with Robert Krause, the exchange’s CEO, and Chief Business Development Officer Charles Barwis, to find out more.

Robert Krause

Andy Webb: What were the origins of the realised
volatility contracts the exchange provides?

Robert Krause: In 1993 the CBOE contracted with
Robert Whaley to design some kind of volatility product. This
resulted in the VIX - essentially an index based on implied
volatility.

At the time, I didn't believe that a contract on implied vol was
necessarily the best direction to take, and so I started thinking
about the possibility of an instrument based on realised
volatility instead. Volatility and variance swaps (which settled
to realised volatility) were already being traded over the
counter, so it seemed to make sense to try to standardise a
product that would mimic a vol swap, rather than try to develop a
completely new approach from scratch.

However, I didn't actually put anything down on paper until 2000
when I attended a conference and sat next to a patent attorney. I
asked him if it was possible to patent such a concept, and he
said yes, so we got the application underway. That wasn't a quick
process; it took until 2008 for the patent to be granted.

Andy Webb: You've taken an unusual approach in
that you aren't building a physical exchange from scratch with
all the infrastructure overheads that implies. Was it always
obvious from the outset that this was a concept that would work
best as a partnership with existing markets?

Robert Krause: It was really a case of research.
Even by the time the patent was awarded, the most suitable
business model for exploiting it wasn't obvious. It was only
after we started talking with exchanges and others in the
industry that the idea of conducting business in this manner
emerged.

Charles Barwis: Part of the key to the success
in launching a new product is distribution. How easy is it for
market participants to get access to your product? We aren't
really directly competing with anybody with this product, so we
don't have to set up our own infrastructure, matching system, and
clearing facilities, etc. Whenever you do have to go down that
route you end up in the classic chicken and egg situation. Some
clients will want to wait until the liquidity develops before
they commit to the development work to write to the API or pay
for a new ISV connection. And that behaviour in turn reduces the
available liquidity needed to get the ball rolling. We don't have
to do that as we have a symbiotic product that is complementary
to whatever the underlying asset happens to be. Therefore, we can
work with entities that already have distribution, be they
exchanges, over-the-counter firms, or whomever.

Robert Krause: We also came to the conclusion
that if we simply arranged straightforward licensing deals with
individual exchanges or other parties then we would lose control
of the message and the final product. It would essentially no
longer be our product, although it might still carry the
Volatility Exchange name. Licensees would be able to tweak the
formula and so on, immediately giving rise to fungibility issues
and making inter-market arbitrage less attractive. We therefore
decided that the best way to exploit the product would be to
brand it, define it, and standardise it. (We have made one
exception to this rule for a variety of business reasons, but
going forward we do not intend to use a licensing model.) As a
result, it doesn't really matter whether the underlying market is
a currency pair or poultry - the formula always remains the same.

Andy Webb: Is it just the method of calculation
you wanted to keep standardised?

Robert Krause: No; we also wanted to make sure
that the product always expired on the same day as any related
options, so as to provide the best possible hedging tool. From
the volatility contract's perspective, it doesn't really matter
whether the contract expires at one time or another, but if it
expires at the same time as the options, then that is far more
useful to anyone trading options and having a volatility exposure
that he or she needs to hedge.

Andy Webb: What was the initial response when
you started talking to exchanges about the new contracts?

Charles Barwis: We received consistently
favourable feedback, whether we were talking to an exchange,
market-maker, hedge fund, retail firm, or even CFD firm. The
first two groups we approached were market-makers and exchanges.
Market-makers have been extremely willing since the outset to
make markets in different groups of realised volatility
contracts. The exchanges have also been very positive, because
they can immediately see the potential.

Andy Webb: You mentioned hedging earlier. How do
you see the application of realised volatility contracts for this
differing from existing hedging methods?

Robert Krause: Market-makers have all kinds of
risks in their option book - delta, gamma, vega, theta, etc. At
present they hedge their delta risk with futures or the
underlying. In so doing, they are effectively trying to marry a
curve with a line, which isn't so easy.

You can more or less draw the tangent to the curve, which is what
you get when you hedge with futures, but there is a constant
adjustment required - and that is delta-neutral hedging.

When you delta-neutral hedge an options book you are still left
with the vega and gamma risk. The vega risk is the risk of gain
or loss resulting from changes in implied volatility, while the
gamma risk is risk of gain or loss resulting from (sometimes
abrupt) changes in delta. At present, vega and gamma risks can
only be managed with options. For example, if you have large
positive vega, you need to sell some options to get flat. (If you
are a VIX trader you can obtain a measure of mitigation by using
the VIX for the vega, but to date, this is viable on only one
asset, the S&P 500.)

The realised volatility contract effectively has both vega- and
gamma-hedging qualities embedded in it, which opens up further
hedging opportunities/efficiencies. We have conducted research
that shows that straightforward delta hedging typically reduces
the risk of an options book by between 50% and 75%. However, if
you add a volatility contract hedge on top of that, you can
reduce the residual risk by a further 50-75%. Therefore early
adopters of realised volatility contracts will enjoy reduced
hedging costs and more accurate hedging, thereby allowing them to
make slightly sharper markets than their peers.

It's also worth noting that option market-makers are in a unique
position regarding realised volatility contracts. Not only are
they likely to be the first adopters to make markets in the
product, they are probably also the primary natural hedging users
of the product.

Andy Webb: What about directional or speculative
trades?

Charles Barwis

Robert Krause: There is an interesting day-trading possibility.
If the market moves 2%, it doesn't matter whether the move is up
or down because it doesn't affect the calculation; it is still
just a 2% move. But what if you are up 2% at midday? Let's assume
the same scenario that the market could go up or down 2% in the
afternoon. If it goes back down, then we will be unchanged on the
day, but if it goes up, then that represents a 4% move, which is
considerable. Therefore there is a very strong directional trade
available intra-day. That trade isn't available inter-day because
at the end of each day you mark the closing price and start
again, but intra-day there is a very strong directional component
during the Realised-Volatility Period. However, I would stress
that this is only available occasionally during the
Realised-Volatility Period (see box "VolContracts" for definition
and mechanics of the contracts).

Andy Webb: And arbitrage or spread trades?

Charles Barwis: There should also be a near
arbitrage (it isn't perfect) between the one- and three-month
contracts; and if we proceed as planned with the roll-out of a
yearly contract as well, then that will obviously provide further
spreading opportunities. We are also talking with some strategic
partners about possibly rolling out a suite of stock indices, so
there could be some interesting spread trades between the
realised volatility contracts traded on each of those indices.

Another interesting characteristic of these contracts is the
range of behaviour they display. For example, the one-month
contract is very volatile compared to the three- or twelve-month
contracts. The one-month VolContract should be highly volatile,
in the order of 80%, 100%, and sometimes a lot more, depending on
the asset. The three-month vol of vol is about one-third of the
one-month version. And, the twelve-month product is about
one-third of the three-month.

Robert Krause: This is basically down to the
averaging period. There are days when markets go crazy and make a
big move, but if you are averaging

over more days than that, the move is dampened. As a result, this
creates three totally different trading animals. The one-month is
very volatile, while the three-month is more akin to the
volatility of many commodities and stocks, and the one-year is
closer to the risk of a government bond in terms of vol.

VolContracts™

VolContracts (Realised Volatility Contracts) are futures-like
financial instruments that capture the inter-day realised
volatility of an underlying asset, index, or instrument. The
one-, three-, and twelve-month contracts allow participants to
hedge, spread/arb, or speculate on realised volatility in the
short-, medium-, or long term.

Contract expiry dates typically coincide with associated
options expirations and the contacts are applicable to any
asset classes with reasonable liquidity, including equity
indices, currencies, rates, and commodities.

The formula used to settle any VolContract on its expiration
day is as follows:

Pt-1 = Underlying Reference Price at the time period
immediately preceding time t

Availability

The first listed instruments based on realised volatility are
due to launch Feb. 7, 2011. VolX and CME Group announced that
CME will begin offering FX VolContracts™ - a set of FX
realised volatility futures based upon the major currency pairs
that it lists. These contracts will be listed with, and subject
to, the rules and regulations of CME.

For further details and contract specifications, see
http://www.cmegroup.com/trading/fx/fx-realized-volatility-futures.html.
For more on The Volatility Exchange, realised volatility and
VolContracts™, see www.volx.us.

Andy Webb: Is there an implication for the trading demographic
here?

I believe day traders and retail traders are very interested in
the directional aspect of volatility, but anyone who is not an
options market-maker struggles to access the volatility market at
present. If you are an options trader, it is labour intensive to
create a pure volatility exposure with options; and once created,
positions require constant monitoring - especially if you are
short volatility.

Charles Barwis: Right now, if you want to trade
volatility in gold, for example, or any other asset other than
S&P or EuroStoxx, you are either an options trader or you
must have access to the OTC volatility/variance swaps market. All
of the other asset classes are therefore, in a sense, closed to
professional trading firms and retail traders that don't trade
options, or don't have access to volatility/variance swaps.

The fund community is in a similar situation and they have a
strong inclination to trade volatility. In general, they see
volatility as an interesting asset class in its own right because
it is uncorrelated with other products they trade, which is
always an attraction.

There is also a subset of the fund community that has emerged in
the past few years that exclusively trades volatility. Some of
that community has access to volatility swaps, which are similar
to realised volatility contracts. They tell us that while they
will continue to trade volatility swaps, our products are
attractive because they are exchange traded and reduce
counterparty risk while increasing transparency. In addition,
they are looking for more products to trade in the volatility
space.

However, the majority of funds trading volatility don't have
access to the volatility swap market, perhaps because they lack
the capital to access the market, or their mandate does not
permit it, or some other reason. For these funds, the more
products they can trade in the exchange-listed volatility space
the better.

Andy Webb: So how would you describe the
essential difference between a realised vol contract and an
implied one such as the VIX?

Robert Krause: VIX is based on implied
volatility, which is essentially the market's forecast of future
volatility. Theoretically the market is supposed to be assessing
what the risk is in the future and putting a price on the option
based on that. If you trade a futures contract that settles to
implied you need to bear in mind that futures are also a forward
forecasting mechanism, because everyone in the futures market is
trying to figure out where the contract will be at expiry.
Therefore, a futures contract on VIX is trying to forecast the
VIX index, which itself is a forecast of future volatility. So
what are you trading when you buy a futures contract on the VIX?
You are effectively trying to forecast the future forecast of
volatility! This is an intangible result that would leave most
market participants wanting.

A vital point to grasp is that if I think 2011 is going to be
really volatile and I trade the VIX, it doesn't matter whether
2011 actually is really volatile, but instead it matters whether
everybody thinks it's going to be volatile. That's a key
difference.

Another interesting distinction is that a VolContract™
actually incorporates implied volatility into its pricing as
well. As far as risk goes, VIX tries to hedge your implied
volatility risk (or vega risk, in option terms), while the
VolContract™ hedges both vega and gamma risk.

Andy Webb: So where do you see the opportunities
with realised vol contracts for automated traders?

Charles Barwis: I believe that in view of its
relatively high volatility, the one-month contract could be a
logical point of interest for high-frequency traders.

The arbitrage opportunities among one-, three-, and twelve-month
contracts could also present opportunities for some specialised
trading firms. Then there is the opportunity to spread-trade
across realised volatility contracts based on various underlying
instruments, or with those underlying instruments themselves.
Finally, there is the chance to take directional positions in
instruments in any time frame, while simultaneously hedging out
the risks of exogenous vol shocks in those instruments. That
minimises the need for human/manual judgement on every trade
where questions arise such as: "Has this trend now really broken
down so I need to follow the stop loss, or is this just a
one-period vol spike?"

Robert Krause: There is also a very strong
embedded directional component within the trading day that is not
available over longer periods because of the very nature of the
contract design (just using daily settlement prices in its
calculation). This effect would allow day traders the ability to
tap into the liquidity of the futures market for spreads,
offsets, and additional trading opportunities with VolContracts.
Automated traders would be best positioned to take advantage of
this embedded directionality.